DIVIDEND POLICY

The term ‘dividend’ refers to that portion of company’s net earnings that is paid out to the equity shareholder (not for preference shareholders, since they are entitled to have a fixed rate of dividend). Dividend policy of a firm decides the portion of earning is to be paid as dividend to ordinary shareholders and the portion that is ploughed back in the firm for investment purpose. The total net earning of equity may be paid as dividend (100% dividend payout ratio), which may consequently result in slower growth and lower market price or a part of net earnings may be paid as dividends, higher capital gains and higher market price. When a company uses part of its net earning for dividend payment then, the remaining earning are retained. Thus, there is an inverse relationship between retained earning and payment of cash dividend –the larger the cash dividend and lesser the retention, smaller the cash dividends and larger retentions. Hence, the alternative use of net earnings or net profit dividends and retained earning are competitive and conflicting.

Dividend decision affects the value of the firm. The cash available for the payment of dividends is affected by the firm’s investment decision, and financing decision. A decision, which is related to investment leads to less cash available for payment of dividends. Thus, there is a relation between investment decision and financing decision. Distribution of net earning between dividends and retention would obviously affect owner’s wealth. The firm has to pay dividends to share holders if dividends lead to the maximization of wealth for them, otherwise the company should retain them for financing profitable investment opportunities.

TYPES OF DIVIDEND

Dividend division of a firm is taken after taking into consideration, its operation and financial condition. When there are variations in these conditions the firm may require to adopt the one that is suitable for the present conditions. What are the different types of dividend policies available to the financial manager? The types of dividend policies are as follows:

Stable Dividend Policy: The term “stability” refers to the consistency or lack of variability in the stream of dividend payments. In more precise terms, stable dividend means payment of a certain minimum amount of dividend regularly. There are three distinct forms of stability, they are:

· Constant Dividend per Share: A company that follows this policy will pay a fixed amount per share as dividend. For example, Rs. 2 as a dividend on the face value of share of Rs. 10 each. The level of earnings would not affect this policy or the dividend payments. This type of dividend policy is more suitable for the company whose earnings are stable over a number of years. Stability of dividend does not mean stagnation in dividend payout. In fact, the prime feature of this policy is to study positive change.

· Constant Payout Ratio: The ratio of dividend to earning is known as payout ratio. On payout ratio. It is also known as constant percentage of net earnings. In this policy a fixed percentage of earnings are paid as dividend each year. Here the ratio is fixed or fixed constant, but dividend per share varies according to the fluctuations in the earnings. For example, if a company follows a 30 per cent payout ratio it means for everyone rupee of net earnings, Re. 0.30 paid as dividends. Assume if a company earned Rs. 10 last year and Rs. 15 in the current year. Then the dividend amount for last year is Rs. 3(10 * 30 / 100) and Rs. 4.5 (15 * 30 / 100) for the current year. The relationship of EPS and DPS is shown below

This policy is stable for a company that is not confident of getting stable earnings.

· Stable Rupee Dividend plus Extra Dividend: Under this policy the management fixes the minimum dividend per share to reduce the possibility of net paying dividend. An extra dividend is paid in the years of prosperity. This type of policy is more suitable to the company having minimum earnings and over the minimum, the earnings may fluctuate.

FACTORS INFLUENCING DIVIDEND POLICY

The determinants of dividend policy will vary from firm to firm. The following are the various factors that have a bearing on the dividend policy

1) Nature of earnings: The nature of business has an important bearing on the dividend policy. The industrial units that are having stability of earnings may formulate (adopt) stable or a more consistent dividend policy than other, which are having unstable earnings, because they can predict easily their earnings. Firms that are involved in necessities suffer less from stable incomes than the firms that are involved in luxury goods. The industries/firms that are having instable earnings should follow a variable or low dividend policy.

2) Age of company: The age of company has more impact on distribution of profits as dividends. A newly started and growing company may require much of its earnings for financing expansion programs or growth requirements and it may follow rigid dividend policy, where in, most of the earnings are retained while an old company. With good track record and good name in the public can formulate a clear cut and more consistent dividend policy. This type of companies may even pay 100 per cent dividend payout ratio and the required amount for growth can be raised from the Public.

3) Liquidity position of company: Generally dividends are paid in the form of the cash hence it entails, cash. Although a firm may have sufficient profits to declare dividends, but it may not have sufficient cash to pay dividends. Thus, availability of cash and sound liquidity of a company depends very much on the investment and financial decisions of a firm, while in turn determining the rate of expansion and the manner of financing. If cash position of a firm is weak, stock dividend will be better and if cash position is good it can go for payment of dividend by cash.

4) Equity shareholders preference for current income: Legally, the Board of Directors has discretion to decide the distribution of the earnings of a firm. The shareholders who are legal owners of the firm appoint the (BOD’s). Hence, directors have to take into consideration owners’ preference, while deciding dividend payment. Shareholders’ preference for current dividends or capital gains, that is, depend on their economic status and the effect of tax differential on dividends and capital gains. When shareholders’ have more preference in current dividend than capital gains, the firm may be required to follow liberal dividend policy, on the other hand if shareholders have preferred capital gains(it may be due to tax or economically sound) than the current dividend, then the firm may be required to retain more earnings.

5) Requirements of institutional investors:-Institutional investors like LICs, GICs, mutual funds (UTI) have investment policy, which says that these types of institutes have to invest only in companies that have a continuous dividend payment record with stability. These purchase large blocks of shares for relatively, to hold a long period of time. Hence, they represent a significant force in the financial markets, and their demand for company’s securities may increase the share price and there by owners’ wealth. To attract institutional investors firms may require following stable dividend policy. Apart from theoretical postulates for the desirability of stable dividends, there are also many empirical studies, classic among being that of Lintner, to support the viewpoint that companies pursue a stable dividend policy. Most firms are in favor of stable dividend per share but they are very careful not to raise dividends per share a level that can safely be sustained in, the future. This cautious creep up of dividends per share result in, stable dividend per share pattern during fluctuating earnings per share periods, and a rising step function pattern of dividends per share during increasing earnings per share periods.

6) Legal Rules: Legal rules restrictions are significant as they provide framework within which dividend policy is formulated. In other words, dividend policy of a firm has to be evolved within the legal framework and rules and regulations. The legal rules have to do with capital impairment rule, net profits and insolvency.

• Capital Impairment Rule: First these provisions require that, the dividend can be paid from earnings either from current year’s earnings or from past years earnings and be reflected in the earned surplus. If the firm pays dividend out of capital, that adversely affects the security of its lenders. The purpose of this rule is to protect creditors by providing sufficient equity base because they have originally relied on that base. Therefore, the financial manager should keep in mind the legal rules while declaring dividends.
• Net Profits: This rule is essentially a result of the earlier rule. A firm can pay cash dividends within the limits of current profits plus accumulate balance of retained earnings. According to Sec. 205 of the Companies Act, 1956, dividends shall be declared or paid only from current profits or past profits after recovery of depreciation. But Central Government is empowered to any company to pay dividend for any financial year out of the profits of the company without providing depreciation. A firm can take profits of past year if the current year’s profits are not sufficient to maintain stable dividend policy. If there are any losses that are to be carried forward, they should be set apart from current years earnings before declaration of dividends. So financial manager has to strong within the boundaries, at the same time has to consider many financial variables and constraints in deciding the amount that is to be paid as dividends.
• Insolvency Rule: A firm is said to be insolvent in two cases. One, in a legal sense, the recorded value of liabilities exceeding the recorded value of asset, or second, as in a technical sense, as the firm’s inability to pay its creditors as obligations came due. If the firm is insolvent in either sense, it is prohibited the payment of dividends. The rationale of this rule is to protect the creditors.

7) Contractual Requirements: Generally lenders may put conditions in a bond indenture or loan agreement often includes a restriction of the payment of dividend. This is done to protect their interest when the firm is experiencing low liquidity or profitability. The restrictions may be in three forms. First, firms may be prohibited from paying dividends in excess to a certain percentage say 10%. Secondly, a ceiling in terms of net profits that may be used for dividend payment may be laid down. Say 50% of net profits or a given absolute amount of net profits can be paid as dividends. Finally, dividends may be restricted by insisting upon a minimum of earnings to be retained. Reinvestment reduces debt equity ratio, which enhances the margin of pillow for the lenders. Therefore, keeping in mind all the restrictions of lenders dividend declaration should be done.

8) Financial Needs of the Company: This is one of the key factors, which influence the dividend policy of a firm. Financial needs, means funds required for foreseeable future investment. The determined funds may be determined with the help of long-term financial forecasts. A firm that has sufficient profitable investment opportunity should follow low dividend payout ratio. On the other hand, a firm that has no profitable investment opportunities or few investment opportunities adopts high dividend payout ratio because owners’ can reinvest dividends elsewhere at higher rate of return then the firm can do, and nominal retention of profits is required to replace the modernize firm’s assets.

9) Access to the Capital Market: Access to the capital market means the firms ability to raise funds from the capital market. A company, which has easy access to the capital market provides that flexibility in deciding dividend policy. Easy access is possible only to the companies that are well established and hence here a profit track record. Generally dividend policy and investment decisions are interrelated, but in this situation they are generally they are independent. The management may tempt to declare a high rate of dividend that attract investors and maintain existing shareholders.

On the other hand, a firm that has difficulty in accessing capital market to raise required funds, will not be able to pay more dividends. It has to depend on internal funds, so management should follow a conservative dividend policy by maintaining a low rate of dividend and plough back a sizeable portion of profits to face any contingency. Likewise, the lending financial institutions advance loans in stiffer terms, it may be desirable to rely on internal sources of financing and accordingly conservative dividend policy should be pursued.

10) Control Objective: Control over the Company is also an important factor, which influences dividend policy. When a firm distributes more earnings as dividends in the form of cash it reduces its cash position. As a result, the firm will have to issue shares to the public to raise funds required to finance investment opportunities that leads to loss of control, since, the existing shareholders will have to share control with new owners. Financing investment projects by the way of internal source avoids loss of control. Hence, if the shareholders and management of the firms are reluctant to dilution of control, thus the firm should retain more earnings for investment programmes, by following conservative dividend policy.

11) Inflation: Inflation is the state of economy in which the prices of products or goods have been increasing. It is a factor which that influences dividend policy indirectly. Indian accounting system is based on historical costs. The funds accumulated from depreciation may not be sufficient to replace the absolute assets or equipment, since depreciation is provided based on historical costs. Consequently, to replace assets and equipments, firm has to depend upon retained earnings, this leads to the payment of low dividend, during inflation period.

12) Dividend Policy of Competitors: Keeping one eye on competitors’ dividend policy is very important. If the firm wants to retain the existing shareholders or it want to maintain share price in the market, and if it is planning to raise funds from public for expansion programs, it has to pay dividends at par with its competitors. Hence, it is one of the factors that influence dividend policy of a firm.

13) Past Dividend Rates of the Company: This is the factor that influences the dividend policy of an existing company. Owners and prospective investors prefer stability in dividends. Stability of dividend means the payment of dividend regularly, at a constant dividend per share. Generally a firm tries to maintain stability in dividends that is based on past dividend rates of the company. Hence, directors will have to keep in mind the past dividends rates.

14) Others: Apart from the above discussed, there are some other factors, which influence dividend policy of a firm, such as trade cycles, corporate taxation policy, attitude of investors group and repayment of loan.

DIVIDEND POLICY IN RELATION TO INDIAN COMPANIES

Dividends are payments made by a company or corporation to its shareholders, usually after making profits. The company may allocate some of its profits for future business development or as reserves and pay another portion to its shareholders. There are no fixed rules for paying dividend, but it is usually the board of directors who recommend such a dividend. It could be paid quarterly, half yearly, annually or even as an interim dividend. The amount paid will be added to the recipient’s total income for tax purposes.

When someone buys a stock in the market, he obviously wants to make a profit out of it. When he receives a dividend from the stock he bought, it is an additional source of profit. Not all the companies declare dividends not all the companies uniformly declare it, even if they manage to.

There is a saying in stock market language: “Never buy a stock thinking that you will get excellent dividend.” True in many cases. Past performance or dividend may not get repeated in future.

In this article let us see how a person, with about 100,000 Indian rupees of investment in April 2006, may have ended up. The selection of companies is at random and the author is no way connected with them nor has any interest or disinterest in them.

Bibliography

Bhat, Sudhindra, (2007), “Financial Management, Principles and Practice”, Excel books, New Delhi.